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3 rule for conversions that are made in The Roth IRA owner can elect to pay tax on the conversion in 2010 or include half the income on the 2011 tax return and half the income on the 2012 tax return. Factors to Consider Before Converting Income-Tax Rates Determining whether a Roth IRA conversion is a good idea depends on a number of factors. The first consideration is the expected income-tax rate at the time of conversion versus the tax rate at the time of distributions from the plan. If tax rates go up, conversion results in a larger accumulation than leaving the funds in a tax-deferred plan. For example, let s compare converting or not converting a \$100,000 IRA in 2010 at a 25 percent tax rate. Assume a 7 percent annual return on the account and a tax rate of 35 percent in 2025 (the assumed year of withdrawal). As you can see in the table below the conversion to a Roth IRA results in an after-tax accumulation of \$206,927, as compared to \$179,337 if the amount remained in the traditional IRA. If tax rates are lower at the time of withdrawal than at the time of conversion the opposite is true. It is better not to convert in that scenario. If tax rates remain the same, the after-tax accumulation is the same in both scenarios. Assumptions Conversion No conversion 2010 (25% effective income-tax rate) \$75,000 \$100,000 Balance 2025 (7% return) \$206,927 \$275, 903 After-tax balance (35% effective income-tax rate) \$206,927 \$179,337 The consideration of the expected income-tax rate on withdrawals is really just the first step. Of course, it is impossible to know with any certainty where income tax rates will go in the future. Source of Taxes One option for paying the taxes at the time of the conversion is to withdraw a portion of the amount converted, thus lowering the Roth IRA balance. It is always better to use another source of funds to pay the tax so that you do not lose the opportunity to earn the tax-free rate of return in the Roth IRA. Remember, a withdrawal from the account could also be subject to the 10 percent penalty tax if the taxpayer is under age 59 ½. 3

4 Tax Diversification Just like diversification of a portfolio, tax diversification can protect against uncertainty and change. For many middle and upper income taxpayers, a significant portion of retirement savings are currently in taxdeferred accounts. Building a source of tax-free income from a Roth IRA can help protect these individuals if future tax rates were to increase. Having different types of income also allows for better income tax planning. Required Minimum Distributions With no required distributions during the participant s lifetime, individuals who do not need Roth IRA withdrawals to meet expenses can continue to accumulate funds for either their later retirement years or as an inheritance to leave to heirs. Estate taxes For those estates subject to estate and inheritance taxes, paying taxes at the time of the conversion reduces the estate and thus the estate tax. The prepayment of the income taxes might be a method to effectively lowering the tax rate on the conversion. Most individuals subject to estate taxation will also prefer to defer withdrawals, building a larger estate. To make sure that heirs will be able to take advantage of stretching out Roth IRA distributions, it s important to plan for another source of funds to pay the estate taxes on the Roth IRA balances in the estate. Life insurance funding is the most common approach to address this issue. Miscellaneous Income-Tax Issues A conversion results in a significant increase in AGI. This can have many unexpected results. For example, it can increase the portion of Social Security benefits that are taxed or result in an increase in the Medicare Part B premium. For this reason, it is critical to discuss the conversion decision with a tax adviser to determine all tax aspects of a proposed conversion. The conversion can have unexpected tax benefits as well. For example, in future years an individual may take tax-free withdrawals from the Roth IRA and such withdrawals will not count toward determining the taxable portion of Social Security or the calculation of the Medicare Part B premium. Value of the Account Taxes paid at the time of the conversion are based on the value of the account on the date of the conversion and conversions relate to the year in which the amount is converted. For example, a conversion on January 15, 2010 can only be treated as a 2010 conversion and the tax will be calculated based on the value of the account on January 15. Converting when the value of the account is at the annual low is optimal, but the future value of any account is unpredictable. However, the IRS actually offers a valuable safety valve for account-value fluctuation. If the account value drops after the conversion but before the due date (with 4

5 extensions) of the tax return for the year of conversion (generally October 15th of the following year) the transaction can be essentially undone through a recharacterization to a traditional IRA and reconversion (if available) in a later year. Asset Protection for the Account The Roth conversion from a traditional IRA should have no impact on creditor protection. However, conversion of money in a qualified plan would remove the extensive protection afforded qualified plans and place the account under the rules for IRAs. Although there were changes to the bankruptcy rules that provide substantial protection of IRAs, this only applies to a debtor in bankruptcy. For those concerned with potential liability, counsel should be consulted about the impact under state law of the conversion of a qualified plan account to a Roth IRA. Who Should Consider a Roth IRA Conversion? Deciding whether to convert is a complex decision. It is important to discuss this with your financial and tax adviser and to consider the decision in the context of the larger retirement and estate-planning picture. However, here are some general guidelines: Many expect that future tax rates for those in the highest income tax bracket will rise. Those in the top 35 percent bracket are candidates for Roth conversions. For a number of reasons an individual can have lower income for a year. This can offer the opportunity to convert at a low (or even zero) tax bracket. Remember, partial conversions are permitted. A common strategy is to convert enough to take advantage of a 15 percent or even 25 percent income-tax rate, assuming that tax rates will be higher later. Those who do not need withdrawals from the account to meet living expenses will benefit from converting as a way to avoid required minimum distributions after age 70 1/2. Taxpayers likely to face a significant estate or inheritance tax should seriously consider converting to maximize after-tax benefits received by heirs. Taxpayers who have accumulated most of their retirement savings on a tax deferred basis need to be considering a Roth conversion of some of the funds as a way to diversify. Taxpayers should consider at least a partial conversion to begin the 5-year required holding period so that distributions will be qualified tax-free withdrawals. (discussed earlier) Any conversion made in 2010 will start the 5-year period as of January 1, 2010 and will apply to any future conversion or contributions to any Roth IRAs created by the same account owner. 5

6 On the other hand, many lower and middle-income taxpayers will have reduced income in retirement and might remain in a lower tax bracket. This generally weighs against conversion, but the potential for tax-diversification or the ability to convert a portion of an account at the lowest brackets may still indicate at least a partial conversion. For those struggling to meet retirement needs, converting reduces available resources by the amount of the income taxes and may not be the best approach unless conversion can be accomplished at a zero or extremely low tax rate. For taxpayers who convert in 2010, the income taxes on the conversion may be deferred into 2011 and If the taxpayer expects income-tax rates to go up in 2011, it might make sense to pay the taxes on the conversion in

7 The Executive Compensation Group, LLC 325 Williamson Boulevard, Suite 120 Daytona Beach, FL Securities and Investment Advisory Services Offered Through M Holdings Securities, Inc., a Registered Broker/Dealer and Investment Adviser, Member FINRA/SIPC. The Executive Compensation Group, LLC is independently owned and operated. The Executive Compensation Group, LLC is a member of M Financial Group. 7

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